The recall that has plagued the pet-food industry over the past several weeks slightly dampened PetSmart's (NASDAQ:PETM) first-quarter performance. As one would expect, the recall was the subject of much discussion in the company's latest quarterly earnings conference call. But as the mantra goes, with crisis there is also opportunity. In this edition of "Fool on Call," we will take a closer look at remarks from the PetSmart call to see how the company has bettered itself through these recent events.
Opportunities for improvement
CEO Phil Francis pointed to two factors that he said negatively affected results in the quarter, particularly during April: the recall and escalating gas prices. After conducting consumer surveys, the company found that the most substantial impact came from "uncertainty" surrounding the recall.
Recalls on certain pet-food items from major brands such as Iams and Eukanuba, both from Procter & Gamble (NYSE:PG), shook customer confidence. What I unexpectedly found from the conference call, however, is that through these events, PetSmart learned a couple of things about how to do its business better. And a better PetSmart is good news for long-term-minded shareholders.
In his prepared remarks, Francis said management believes that the "reactions to the recall are short-term" and that PetSmart is looking at ways to bring customers back to the stores as well as "regain customer confidence."
One way the retailer is connecting with the customer is through Pet Perks. Everyone from coffee slingers like Starbucks (NASDAQ:SBUX) to booksellers like Barnes & Noble (NYSE:BKS) are using loyalty-card programs of this type, but in the midst of the massive recall, PetSmart did something with its cards that set it apart.
"We gained some trust with pet parents when we used the Pet Perks card to reach out to customers and notify them of the possible danger to their pet during the recall," Francis said. He added: "We had a number of customers tell us after many years of carrying loyalty cards, finally someone did something with the information that they considered valuable, possibly saving the life of their pet." Francis hopes the company can continue to reach out to its customers through the program and invite them back to the stores.
Improving profitability
When customers do return, they will find some subtle changes to the store-floor layouts. In May, Francis said, PetSmart has been implementing a complete reset of all of the aisles in its stores, by placing "products of similar pricing and nutrition content together." The change is intended to help customers comparison-shop so they can more easily find the products that best suit their pets. The aisle reset will also make it easier to train sales associates, who can then better educate their customers on the store's products.
Beyond the company's constructive response to the recall, PetSmart also moved ahead with some other initiatives during the quarter to make operations more efficient. The aim was to reduce costs without compromising the shopping experience for customers. The company also worked on labor management as well as on simplifying store processes and supply lines.
If you look at the latest numbers -- gross margin falling to 30.5%, down from 30.7% a year ago, and operating margin shrinking to 6.9%, down from 7.4% -- you may wonder what effect these initiatives really had. CFO Ray Storck explained that the company did manage to allocate its resources more efficiently and leverage expenses with more success, but he added that several other factors offset the improvements -- including increased supply-chain costs related to higher haul rates and fuel surcharges, start-up costs related to a new distribution center, strong redemption numbers from the Pet Perks program, and unexpected costs arising from the recall.
Despite the shortfall in the first quarter, management is sticking by its guidance of a 20- to 25-basis-point improvement to operating margins this fiscal year. One way it will continue leveraging what are often more stable operational expenses is through store expansion. The company opened up 20 new stores in the first quarter and remains on track to open up 100 units for the year.
PetSmart impresses
The pet retailer faced significant challenges in the first quarter, but based on remarks I heard in the call, I come away even more impressed with this company. It's a Motley Fool Stock Advisor selection and a five-star pick in the Foolish investment community, Motley Fool CAPS, for a good reason -- it is simply a well-managed operation.
Although no one can be sure whether the troubles that spurred the recall are indeed over, the company continues to find more clarity as scientists and regulators narrow in on the specific problem. Despite the continuing uncertainty, PetSmart is finding ways to improve communication with its customers, a strategy that should pay dividends once the recall has passed.
As the recall concerns begins to subside, look for more aggressive advertising throughout the remainder of the year in an attempt to bring customers back. We learned in the question-and-answer portion of the call that PetSmart had previously (and fortuitously) allocated a greater percentage of marketing dollars to be used in quarters two through four. Plus, it was able to shift some unused ad funds from Q1 to Q2. And finally, we learned that it will be partnering with several pet-food producers in a concerted advertising effort. Because of these efforts, ad dollars for the remainder of the year shouldn't be way out of whack.
In addition to store improvements and increased communication with customers, PetSmart will stick with its aggressive growth plans. This year, the company will surpass the 1,000-unit mark, on track to meet its ultimate goal of opening up roughly 1,400 stores in the United States and Canada.
CEO Phil Francis explains that what's driving growth is the continued "humanization" of the pet. Despite the recent challenges, the continued shift from Fido the pet to Frankie the four-legged family member is undeterred. And the humanization of Fido is why, in the entire retailing world, PetSmart should remain high on the watch list among prospective investors.
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Fool contributor Jeremy MacNealy has no financial interest in any company mentioned. The Motley Fool has a disclosure policy.
